Freeport-McMoRan (NYSE:FCX) recently announced the resumption of its exports after it struck a deal with the Indonesian government to build a smelter in the country. In the past, we have discussed the issue with Indonesian government and how it would impact the company based on the 25% royalty it had to pay as of its initial proposal. The export of the company were halted for quite some time and, better late than never, the company managed to make a good deal for itself. In this article, we will conduct an analysis based on the increase of unit net cash cost of copper in Grasberg to find out how much burden this deal will cause to the company. Furthermore, we will briefly look into the foreseeable global demand for copper in the coming months and discuss the company's opportunities and threats.
The Price Tag on Grasberg
The higher cost associated with the extraction in the region and royalties which the company was already paying to the stakeholders have been weighing on the profitability of the company. In addition, the treatment charges were also higher in this particular region as compared to the company's resources in other geographical areas. For these reasons, the company was already operating under gross loss from Indonesian region. However, other regions have more than made up for this setback up till now and are likely to continue to do so.
With the new royalty rates and export duties, the company would have to give a bigger piece of the pie to the government which means it is headed for further gross loss unless the price of copper rises. Here, we will have a rough idea of how much of a setback the company is likely to face and for how long it will face it.
According to the recent news release, Indonesian government will now increase royalties to 4% on copper and 3.75% on gold which were previously 3.5% and 1%, respectively - the export duties will take effect immediately. Initially, the duty will by 7.5%, which will later decline to five 5% as the smelter passes 7.5% development. The duty will remain at 5% until 30% smelter progress after which it will become 0%.
If we look at second quarter, the royalties paid are at $0.11 per pound of copper/per ounce of gold at the current royalty rates. With that, the unit net cash cost becomes $2.66 per pound/ounce of gold. After incorporating some other costs, the company goes into a gross loss of $0.37 per pound/ounce.
With the new royalty rates and export duties in effect, the company will have to bear an even higher cost. The effective tax rate is also the highest in the country at 40%, compared to other interests of Freeport-McMoRan. The following picture gives a clear idea of what the Indonesian subsidiary is contributing to the company. Although in losses in Indonesia, Freeport is at a far greater advantage in South America, North America and Africa.
Source: SEC Filings
When Will The Situation Get Better?
Although under losses, Freeport Indonesia is still the largest gold mine and the third largest copper mine in the world. The company will have to make some adjustments and incur some cost to build smelters, but this could turn out to be good for the company. Firstly, it took copper ore to other countries where it processed it into different element. Now, with the smelter in Indonesia, it can save that cost and directly sell the final product from Indonesia. This will increase the profit margin of the company from the region.
Copper prices have been favorable since the month of July due to the increased global demand. This increased demand is the result of expected greater copper demand from China due to industrial expansion. The actual growth in demand will be clear over the next few months, and if the actual demand goes above the expected demand, then we are likely to see a continued rise in copper prices - however, if the actual demand falls short of the expectations, then we might see a decline in the copper prices. Nonetheless, this gives Freeport-McMoRan at least one quarter of favorable copper prices for sure.
The agreement with the Indonesian government is not ideal but it looks like a good deal for the company in the long-term. In the short-term, however, the company will continue to have a loss from the region as the royalties will increase. Further, the decision to build a smelter in Indonesia will also result in a considerable rise in the capital expenditures of the company. Copper prices are also favorable for the copper producers and the expected demand a supply situation is indicating that the prices will remain strong. We believe these factors are favorable for Freeport-McMoRan and the company is well-positioned to grow.
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